Advisers Must Avoid ‘Due-Diligence Lite’ on Asset Managers

By Daisy Maxie

September 10, 2014 Wall Street Journal

The regulatory troubles of F-Squared Investments are a reminder to brokers and investment advisers of the need to do more than simply review the numbers a mutual fund company or other asset manager offers to demonstrate financial health and prowess.

Analyzing how the company arrived at the numbers is critical, specialists in vetting asset managers say. F-Squared, which builds portfolios of exchange-traded funds, recently acknowledged a deepening investigation by the Securities and Exchange Commission into how it marketed some funds’ past performance.

While brokerages and investment-advisory firms are doing more due diligence than they used to on alternative investments before they agree to put client money into them, too often they’re not showing the same care in analyzing conventional products, says Jonathan Henschen, president of industry recruiting firm Henschen & Associates.

Many small- and mid-sized brokerage firms handle due diligence on money managers internally. Some use computer databases to check on an asset-management firm’s registration and background, including information on its principals, court records and any tax liens. Typically they will want to see that the firm has sufficient scale and a history of at least 10 years or so, Mr. Henschen says.

He calls this approach “due-diligence lite.”

“They’ve got to meet their due diligence with the regulators, but they’re not digging into their accounting at all,” Mr. Henschen says.

Many of the broker-dealers “tend to be like sheep,” he says. “If other big firms are using it, well, it must be okay.”

Some brokerages dig deeper, or employ third-part specialists to help. In terms of ensuring that a performance record is accurate, most check to see if it is “GIPS compliant”–that is, it conforms to the Global Investment Performance Standards, a set of standards for calculating and presenting investment performance approved by the CFA Institute.

A number of firms, including the Spaulding Group, Ashland Partners & Co. and PricewaterhouseCoopers, conduct such verifications. Richard Kemmling, president of Ashland Partners in Jacksonville, Ore., says his firm will ask for a performance record from an adviser, then request source documents–which in many cases are bank statements from the adviser–to back that record up. Ashland Partners randomly confirms the documents with the banks, he says.

If an adviser can’t provide back-up documents, he says, Ashland Partners will not go forward with a verification. “That’s certainly not the rule, but it has happened to us before,” Mr. Kemmling says.

If a firm’s numbers are not GIPS-compliant, its performance record still can be verified with the proper documents, he says.

Mistakes in the numbers are common, Mr. Kemmling says. And verification isn’t fool-proof.

Sometimes certain marketing materials or advertising by an asset manager may fall outside the scope of the verification, he adds. “There’s always a bit of risk,” he says, even when third-party specialists have signed off on a company.

Capital Market Consultants was among verification firms that had signed off on F-Squared—until word of the SEC’s investigation of the firm came out last year. “We told our clients six months or so ago not to use F-Squared any more,” says Barry Mendelson, its chief executive. Several large brokerages have also distanced themselves from F-Squared; RBC Wealth Management and Raymond James Financial Inc., for example, have set limits on how much new business its advisers can conduct with F-Squared, The Wall Street Journal reported last week.

Based in Milwaukee, Capital Market Consultant vets investment managers for banks, multi-family offices, wealth managers and broker-dealers. Mr. Mendelson says the nature of F-Squared’s number troubles made them very difficult for any verification firm to spot. They involve advertised returns from April 2001 to September 2008, which were based on data that the SEC found weren’t derived from actual management of client assets, F-Squared has said.

“We didn’t understand that they were hypothetical,” says Mr. Mendelson. “If we aren’t given that information, and it’s not disclosed, it’s hard for us to go into their spreadsheets to figure out for ourselves what the performance is.”

F-Squared says it has improved its controls and corrected the marketing materials in question. The company has been “transparent and supportive” with its partners throughout the process, it said in a statement, and points to continuing strong sales as a sign of confidence in its funds.

When evaluating managed portfolios of ETFs, like those run by F-Squared, advisers need to ask the right questions to get a sound understanding of the interaction between all the cogs in a strategy’s machinery–its data inputs, investment model, trade execution and so on, says Ling-Wei Hew, an analyst at Morningstar Inc.

“The list of suitable questions is a lengthy one,” she says, “but a solid understanding of a strategy’s investment process and implementation should provide the necessary foundation to turn over all stones.”